July Emerging Markets Update

Monthly Commentary

Another One Bites the Dust? Putting Turkish Stress Into Context:

In the 2013 Taper Tantrum*, the market zeroed in on Fragile Five economies vulnerable to capital market outflows – South Africa, Brazil, India, Indonesia, and Turkey. At the time there was a fear of contagion should one of these economies experience a sudden stop in capital flows. Under pressure from that experience, we have seen some degree of adjustment in four of these economies (i.e. improved current account deficits, lower inflation) so that now the immediate Emerging Markets (EM) vulnerability discussion centers almost exclusively on Turkey and Argentina.

Turkey escaped 2013 benefiting from falling global yields and (at the time) cheap oil. Unlike most other vulnerable EMs, however, the Turkish government doubled-down on unorthodox economic policies, compromising the independence of the central bank and pursuing growth at any price, paying for it with a combination of looser fiscal policy and a substantial run-up in off-balance sheet spending. This led to a sharp increase in Turkish inflation (~16% y/y and rising) and a large current account deficit that stood at 6.5% of GDP in early 2018. At the same time, heightened political and geopolitical risks discouraged foreign direct investment into Turkey and resulted in greater reliance on short-term portfolio flows to finance the growing imbalances. It is therefore not surprising that Turkey stares at a crisis in an environment of tightening global liquidity.

Turkey is almost certainly now headed into recession as market participants discuss the options of capital controls or an IMF bail-out (neither of which we think likely before significant further pain). Investors have understandably become concerned about Turkish contagion, inducing a market wide risk off trade. Contagion generally proceeds along one or more of the following channels: confidence crisis resulting in rapid FX depreciation leading to portfolio outflows, spiking corporate defaults, financial sector stress, and trade disruptions. Of these, given the relatively modest size of the Turkish economy (USD 800 billion until the most recent spike in USD-TRY), we are primarily concerned about portfolio outflows and financial sector contagion (with considerable European bank exposure to Turkey).

As pointed out by the Financial Times last week, using BIS
statistics, local lenders, including foreign owned subsidiaries,
have dollar claims of USD 148 billion and Euro claims of
EUR 110 billion. More specifically, the aggregate exposure
of Spanish, French and Italian banks to Turkish borrowers
is USD 139 billion. Correspondingly, we witnessed a sharp
spike in CDS for Unicredit and BBVA last Friday that,
along with BNP, have Turkish subsidiaries. The stress in
the Turkish financial system is clearly rising as the country
has experienced an increase in corporate defaults in recent
months, including by some relatively high profile firms.
Further tightening of financial conditions is likely to exacerbate
this stress.

Now for the Silver Lining…

Developed Markets (DM) growth is in a (fairly) good
place. Unlike the 2013 episode, DM growth is solidly
above potential, led by the U.S., which is benefitting from
a pro-cyclical stimulus via the tax cut. Japan appears to be
shrugging off its 1H18 slowdown and the most recent data
from Europe and Germany (2Q GDP) surprised somewhat
to the upside despite widespread concerns about U.S.
protectionism and tariffs against European firms.

In many respects, China remains the most important EM
anchor. Policymakers there are in the middle of a targeted
stimulus to offset external shock from the trade war. We
believe there will be a measured deceleration in Chinese
growth, but risks of a sharp slowdown are quite limited
with ample policy tools to support growth in case of further
external shocks.

Looking at market positioning – with the exception of select
credit investors – other investor groups were already roughly
neutral Turkish assets and have been reducing their exposure
year-to-date, lowering scope for incremental outflows.
Turkey’s sovereign balance sheet as it stands today is not
the source of vulnerability with a public debt to GDP ratio
(strictly defined) below 30%. The main vulnerability is the
private corporate FX mismatch and its potential to impact
debt service capacity, which in turn could affect bank balance
sheets and, by extension, the sovereign.

In addition, Turkey is a real outlier in EM in terms of its
vulnerability. We can’t emphasize enough the stronger policy
mix and better reserve positions of the remainder of the EM
complex, providing other countries with tools to withstand
external shocks. Even Argentina, for all its vulnerabilities,
recently secured a $50 billion IMF package that covers the
sovereign’s financing needs for the next two years. Thus, the
risk of a broad sudden stop in capital flows to EM remains
quite low, in our view.

Should we be proven wrong and broad-based financial stress
intensifies, we believe the notion of a “DM central bank put”
is still valid, albeit with a lower strike. Thus, while there is
currently no reason for the European Central Bank (ECB) or
the Fed to change its policy path, additional system stress
could change the reaction function. This is especially true of
the ECB due to Europe’s greater trade and financial linkages
to Turkey.

Turkey has some obvious steps to buy itself space and lower
risk perception:

Accommodating U.S. demands to free Pastor Andrew
Brunson in exchange for sanctions relief. Erdogan’s recent
rhetoric (August 10 NY Times op-ed) suggests no quick
resolution on this issue but dialogue is ongoing (see the
August 13 meeting between Turkey’s Ambassador to the
U.S. and Trump’s National Security Advisor John Bolton).

A robust monetary policy response, with the Central Bank
of Turkey raising rates aggressively to tame inflation. An
aggressive monetary response is needed both to stabilize
confidence in the lira and to limit the secondary inflation
impact of the steep FX depreciation to date. In the short
term, Turkish authorities have taken technical steps to help
shore up the market, provide short-term financial stability
and reduce speculative positions, but this is not sufficient
to address the underlying problem.

A large and credible fiscal adjustment (to be communicated
in detail soon and implemented quickly) would boost the
prospects for a softer landing of the economy and help to
deliver a manageable deleveraging process. Slower Turkish
growth with greater reliance on exports (likely to be boosted
by the huge TRY depreciation) could pave the way for a
sustained external adjustment assuming the government
and central bank can deliver a strong and orthodox policy
response. It goes without saying that all of this would be
easier if Turkey were to ask the IMF for support, but as of
now this is opposed by Erdogan.

EM valuations have turned supportive across both debt and
equity, while the market is generally underweight EM. Spreads
on the EMBI have widened out from the 2018 tights of 260
basis points (bps) to ~370bps, which is 20 bps wide of long
term averages. The MSCI EM has pulled back close to 20%
from its January 2018 peak and pockets of the market look
deeply oversold. Some of the recent market moves appear
to be exacerbated by technicals, as the markets tend to be
less liquid in August. We see the solid fundamentals in EM
cushioning EM markets from full-blown contagion, although
weakness could persist in the near term until there is more
clarity on the path that Turkey will take. Correspondingly,
while we think in the near term we may see stress, especially
for the assets that will be viewed by the market as spillover
risk hedges (South Africa, Indonesia) and short term liquidity
driven pressure as outflows force managers to liquidate across
their broader portfolios, ultimately contagion risks from Turkey
are likely to be contained, in our view. Historically, liquidity
driven market sell-offs tend to be short and ultimately present
attractive opportunities as policymakers respond to market
pressure and concerns over widespread contagion abate.

* Taper Tantrum: Surge in U.S. Treasury yields, which resulted from the Federal Reserve’s use of tapering to gradually reduce the amount of money it was feeding into the economy.